All Terrain Thinking

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Economics: It's not just whats' in your wallet

Introduction to Economics: Alternative Systems and Perspectives

In this Unit we will look at three issues:

• Alternative Economic Systems
• Alternative Ideologies
• How Much Math

Alternative Economic Systems

It should not surprise that over the centuries many solutions to the basic economic problems have been tried, and each solution is unique. The economic system in ancient Greece was different from the current system in the US, which is substantially different from the system in China. Rather than focusing on the differences in the myriad of economic systems that have existed, we will focus our attention on similarities and discuss three major types - Traditional, Command, and Market Systems.

The differences between the systems is readily apparent when you look at your career - how you found yourself in engineering or business or TMD and others did not. One approach to allocating the limited number of "university slots" would be to allocate them the way they had always been allocated. If your parents went to college, then you would go to college: if your father was an engineer, then you would be an engineer.  Scarce resources would be allocated as they had always been - by Tradition.

A alternative approach would have been to have some "BIG BOSS" make the decisions on who would go to college and who would major in engineering.  For this system to run we would need a modern day Pharaoh or Czar with the power to decide how many engineers are needed, who they should be, and where they should work.  In this world scarce resources would be allocated by Command.

And then there is the system in which you chose to be an engineering student.  For some the choice may have been made because a parent enjoys life as an engineer; for others it may be the higher than average starting salaries for college graduates with an engineering degree; and for others it may be the love of applied mathematics that was the deciding factor in the choice.  Regardless of the reason, in each case you have chosen the engineering route.

Now imagine an entire system in which scarce resources would be allocated by the choices of individuals. This is a Market system which is pictured below in Diagram 1.  For this system to be effective, decision makers such as you need both the information necessary to make informed choices and the incentive to make those choices.  In the market system, prices provide the necessary information while property rights that enable the owners of property to use the property and to sell it, provide the incentives. Getting back to the career choice problem, you have decided to be an engineer because the price (income) was right and with your new wealth you would be able to obtain those things which mattered most to you.

Diagram 1
Structure of Market System

The analysis of this choice of career, as well as the choice of someone to teach you economics, would be the subject matter of Microeconomics where the emphasis is on individual choice.  Here the focus is on the explanation of choices made by individuals and firms - how many hours to work, how many children to have, how much output to produce, and how many workers to employ. The basic premise in microeconomics is that firms are pursuing profit while individuals / households are pursuing their self interest.   As you will hear me say many times, we look at decision makers as calculators continuously weighing the costs against the benefits associated with any decision/choice.  

But how do we avoid chaos when all decision makers are pursuing their self interest? The "secret" is in the interaction between the individual decision makers. The nature of the interaction can be seen below in a very simple version of the Circular Flow Diagram that identifies three major aggregate markets (output, capital, and labor) that tend to bind the decision makers (households, firms, and government) together.  Households / individuals buy goods and services in the output market, sell labor in the labor market, and borrow money (mortgages, car loan) and lend money (savings account, mutual fund) in the capital market.

Diagram 2
Circular Flow Diagram

In the case of your career choice, the logic of the system would go something like this.  In the output market we would find evidence that people want computers.  The output market would send a signal (profits) to firms that would prompt them to raise the production level of computers.  This generates a need (demand) for more electrical engineers and the labor market would send out a signal (higher wages for engineers).  We would expect people to respond in a predictable fashion to the signal.  Because people can keep the money earned from selling their skills, more people will decide to become engineers as the wages of engineers increases.   As more people decide to become engineers there will be more people needing to borrow money to finance their schooling and the capital market will send out the appropriate signal (higher price). The higher interest rates (price of money) should increase savings which should result in an inflow of money into the capital market that will mean adequate financing is available for the new students.

The analysis of what goes on in these markets, because it is at the center of the market system, will be the discussed at the outset of both courses as we examine the supply - demand model of prices.

In Macroeconomics the emphasis is on how well these aggregate markets function.   Can we expect the labor market to function effectively so all people looking for work can find it?  Will there be a job waiting for you when you graduate? Can we expect the output market to function properly?  Will there be inflation that will erode the buying power of your earnings, and will there be growth so we can enjoy a future in which the standard of living continues to rise? And will the capital market provide enough funds so people can borrow money to finance their education and buy their cars and homes on credit, or will there be a return to 18 percent mortgage rates and credit crunches.

Before we begin our detailed discussion of either micro or macro, we will take a moment to discuss some of the alternative perspectives on economic systems.   Economists are notorious for their ability to disagree and we will briefly examine one source of disagreement - what some would call an ideological perspective.

Overview of Alternative Perspectives (Ideologies)

Anyone who listened to even a little of the committee hearings on Bill Clinton's impeachment in December of 1998 knows of the power of political parties.  Regardless of one's views on the validity of the charges, there was no question this was a partisan effort where you could identify a person's party from his / her comments.  There is a difference between the way Republicans and Democrats see the world and this is reflected in nearly all that they say and do. 

The same is true to some extent in economics. When you ask an economist the question, which economic system is the "Best," the answer you get will depend very much upon the economist's view the world - on what would be called ideology.  Whereas in politics we have the Democrats and Republicans, in contemporary economic thought, the debate on which is the best economic system is generally between the two ideological groups that would fall within the midrange of the ideological spectrum - Conservatives and Liberals - whose opinions and theories you might expect to see in print on the pages of The Wall Street Journal and The New York Times.  For a brief overview of the alternative perspectives you should check out the History of Economics web site.

Conservatives tend to possess a general distrust of the state and an unending faith in the supremacy of "free enterprise" as a mechanism for allocating resources and promoting growth. The Father of Conservative economists would be Adam Smith who wrote The Wealth of Nations in 1775. The capitalist economic system allows allocation decisions to be made in a decentralized fashion by individuals pursuing their own self interest.  According to Smith, "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."  More importantly, this system based on individual choice will tend to operate optimally.  Again in Smith's words: "...by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this...led by an invisible hand to promote an end which was no part of his intention."  For conservatives, a good government is a small government that simply sets the "rules" to govern the competition.  In his book Smith describes the situation as follow: 

All systems either of preference or of restraint, therefore, being thus completely taken away, the obvious and simple system of natural liberty establishes itself of its own accord. Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest his own way, and to bring both his industry and capital into competition with those of any other man, or order of men. The sovereign is completely discharged from a duty, in the attempting to perform which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it towards the employments most suitable to the interest of society. (Book 4, Chapter 9):

Liberals, meanwhile, share with the Conservatives a strong faith in the market, but believe there are advantages to be gained by moving to a "compromise" position where the government is able to devise policies to offset some of the "structural flaws" of the system.  Liberal theorists believed they had proven the existence of instances where the capitalist system would behave less than optimally, including a tendency to produce unacceptable and avoidable levels of economic instability. One of the more influential liberals, and the father of modern macroeconomics, is John Maynard Keynes who wrote The General Theory of Employment Interest and Money. In his critique of the prevailing conservative theory, Keynes wrote:

"Now 'in the long run' this is probably true.... But this **long run** is a misleading guide to current affairs. In the long run we are all dead.  Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again." 

As Keynes saw it, the conservative view that emphasized the power of markets to allocate resources may be an adequate explanation of what would happen in the long-run, but we may not have the will to wait that long.

The differences between these two views will be a reoccurring theme in both macroeconomics and microeconomics. In microeconomics one of the issues you would be likely to talk about would be the education industry.  Liberals tend to believe education is too important to be left to the private sector because we can expect the private sector will provide less education than would be best for our society. Their solution is the public provision of education - institutions such as University where the cost of education is subsidized by the general public. Conservatives, meanwhile, tend to believe the market system will provide adequate levels of education and the secret to improving our educational system is privatization. 

In macroeconomics, some of the most heated debates are likely to be about the ability of the government to alter macroeconomic performance with the use of monetary and fiscal policies - printing more money or raising government spending.  The questions you will look into here are: How much money should be in the system and who should control it? How big should the level of government spending be and should we view the level of government spending as a tool to reduce the level of unemployment? Should Japan's government increase government spending to move the country out of a long-running recession? Should the Fed raise interest rates to head off future inflation?  Conservatives tend to push for limited discretionary policies on the part of both monetary and fiscal authorities while liberals tend to believe that discretionary monetary and fiscal policies should be employed to improve the performance of the macro economy. 

This story will be told, to the extent that it is possible, in the third person. Less effort will be spent taking sides and more on describing how economic theory and policy have swung back and forth between these two views over the past sixty years. We will focus our attention on how new ideas develop as the economy changes in ways that old theories find hard to explain - how the new theories become an orthodoxy that eventually becomes incapable of explaining new facts, leading to the rise of yet another set of new ideas. 

As we move forward we will see there is clearly a parallel between economic theory, economic policy, and economic performance.  Economic policies will be grounded in the prevailing economic theories and there will be little pressure to unseat these theories or policies as long as the economy is performing adequately.  It is only in times of economic crises that there is any real movement in public policies and any shift in the balance of power among theorists - a reversal of the ideological pendulum.  Bruno and Easterly (1996) suggest that economic crises, in this case crises triggered by bouts of hyperinflation, can speed the process of economic reform in lower income countries and the return of growth will be faster in those countries that experienced the hyperinflation.  If we follow the logic a bit further we end up where Albert Hirschman (1987) did and conclude that "inflation has acted as the equivalent of war in eliciting change" or Alesina and Drazen (1991) who "model delayed stabilization as a war of attrition." 

Diagram1
Ideological Pendulum

As we work our way through the story you will find there are two dominant themes. One theme is the proper scope of government - a theme that actually pervades all economics courses and discussions.  It is the flip side of the discussion of how well the economy operates on its own - on the adequacy of the economy's self-adjustment mechanisms to deal with the inevitable external shocks such as the Asian financial crises of 1997-98. 

Although our discussions of microeconomics and macroeconomics will be focused on the ideological spectrum spanned by conservatives and liberals, there are important ideas about economics that do not fall in that range.  One would be Marxism, the economic theory attributed to Karl Marx who wrote during the second half of the 19th century.  Where Adam Smith saw Capitalism as possessing a potential for unprecedented economic growth, Marx saw it as possessing a fatal flaw that would eventually bring about its collapse.  Capitalism was simply an intermediate stage in the evolution of economic systems and it would eventually fall under its own weight.    In fact, much of the post WW II era can be viewed as a battle between two economic / political systems - capitalism (market control) in the West vs. communism (command control) in the East.  When the wall between Eastern and Western Europe came down at the beginning of the 1990s, the consensus was that capitalism had proved itself superior to communism and that the ideological debate had been settled.  This is undoubtedly an optimistic view and you can expect that Marxism / communism will be around for quite some time.

Now for the question so many of you have been waiting for: How much math will you need? As you saw earlier, economics involves story telling and the teller of the story has a considerable say in how much math will be used in the story.  While my college degree was in mathematics and I believe very strongly that adequate quantitative skills would be on the short-list of skills which all students should posses upon graduation from college, there is no need to rely on sophisticated mathematical / statistical techniques to tell the stories which will be told in this course. 

There are actually four ways in which to tell our stories, and during this semester you will run into examples of all of these. The four forms for story telling are:

• Verbal
• Tabular
• Graphical
• Algebraic

To give you an idea of the differences in the "presentation" of the story, consider the following rather simple story about population growth.  In the past few years we have heard much about the rapid growth of the world's population and the havoc it is wreaking on the environment, but how important are the proposals which would reduce the growth rate of the world's population.

As a first step toward answering this question, let's look at the situation in twenty years if the current situation remains unchanged. At the present time the world's population is approximately 5.8 billion and it is growing at a rate of 1.4 percent per year. If it continues to grow at that rate, then the world's population in ten years would be 6.67 billion, and at the end of twenty years it would be nearly 7.7 billion people.  So much for the verbal approach.

In addition to the verbal representation, the story of population growth could also have been told using a table such as the one below. The advantage of this is that more information can be seen quickly - we can see what the population would have been at six different points in time in the future.

Or you could present the relationship between time and population with a graph comparable to the one below. The advantage of the graph is we see the continuous growth of the population for the twenty years.  The disadvantage is we cannot read off what the population would be in any one year.

Finally, for those who have a good command of mathematics, we could use the algebraic version. The solution for the world's population in twenty years [Pop (20)] using the equation would be:

Pop(20) = 5.8*(1.014)²⁰ = 7.66

Each approach has its advantages and disadvantages, each appeals to a different audience. The equation approach is likely to be a favorite among engineering students, while the verbal approach would be the favorite among humanities students. In this course mathematics will not get in the way of the story. You can expect the weighting to be heavy on the verbal with some graphical and tabular work and almost no algebra.

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